Secured debt and the non-debt tax shield hypothesis

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DeAngelo and Masulis (1980)'s non-debt tax shield (NDTS) hypothesis suggests that there is a negative relation between leverage and non-debt tax shelters. However, all extant empirical literature has failed to document any negative relationship between different measures of leverage and non-debt tax shelter proxies at the firm data level. The generally found zero or significant positive relationship between leverage and NDTS proxies casts doubt on the empirical validity of the NDTS hypothesis and the authors have offered the "secured debt effect" as a possible explanation. The current research explores the following questions. 1) Is firms' choice of secured debt a contaminating factor that causes the perverse empirical relationship between leverage and non-debt tax shield proxies? 2) If indeed firms' choice of secured debt is a contaminating factor, could it have also affected the empirical relationship between leverage and its other conventional determinants? 3) Is there other factor, beside secured debt, that could have also caused the perverse empirical leverage-NDTS relationship? This research derives a theoretical model to explain the cause of the perverse empirical relationship between leverage and the NDTS proxy. The model involves exploring the trade off between NDTS effect and secured debt effect in a general capital structure model which incorporates bankruptcy cost, non-debt tax shelters and other agency related costs, such as monitoring and collateral-related costs. This set the stage to define a secured debt proxy in order to empirically verify if indeed the secured debt was a contaminating factor in the earlier cross-sectional studies. Separately, the current study recognizes that the NDTS argument is also linked to firms' cash flow distributions. Specifically, the NDTS argument can be shown to predict different degrees of leverage for firms that have same level of NDTS but different cash flow distributions. This suggests that without controlling for the interaction between the level of NDTS and the underlying cash flow distribution, it is difficult to test the NDTS hypothesis by only examining the relationship between leverage and the level of NDTS. An attempt is made in the current study to at least partially control for such interaction by introducing a new NDTS proxy which combines the level of the NDTS and the parameters of the underlying cash flow distribution. The empirical tests conducted in the current research require the construction of a secured debt proxy. The construction of the secured debt proxy is novel because, to my knowledge, it is the first of its kind in any cross- sectional empirical study on capital structure. Furthermore, a classification scheme is developed with the objective to isolate possible secured debt effect from the leverage-NDTS relationship. The performed empirical tests have produced some evidence that supports the secured debt and the cash flow distribution explanations.

Corporate debt--United States, Tax shelters--United States